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The Tale of the Seafaring Real Estate Professional

Originally published in: The New York Law Journal April 25, 2012 The Tale of the Seafaring Real Estate Professional By: Ezra Dyckman and Libin Zhang Prior to the enactment in 1986 of the passive activity loss rules in the Internal Revenue Code (IRC), many lawyers, doctors, and other high-income individuals would invest in tax shelters that generated tax losses, which could be used to offset their other income. Popular tax shelters involved real estate, farming, and oil and gas, all of which were designed to require little managerial input from the investor. The passive activity loss rules now prevent an individual taxpayer from deducting his losses from certain “passive” activities against that individual’s active income (such as wages) or portfolio income (such as interest and dividends). A trade or business activity is considered passive for a taxable year if the individual does not materially participate in the activity during the taxable year. However, nearly all rental real estate activities are considered per se passive activities, regardless of the taxpayer’s level of involvement, unless the taxpayer can prove that he is a “real estate professional.” Real estate professionals generally include property developers, construction contractors, real estate brokers, hotel managers, and other professionals working full-time in the real estate business. The taxpayer in Miller v. Commissioner, TC Memo 2011-219, Ezra Dyckman is a partner in, and Libin Zhang is an associate of, the law firm of Roberts & Holland LLP. managed the rare feat of proving that he was a real estate professional while also holding a regular job as a ship captain. Miller v. Commissioner Tom Miller lived in the San Francisco Bay area with his wife, Nancy Miller. Tom worked for the San Francisco Bar Pilots Association (SFBPA) as a ship pilot, where his schedule consisted of working seven days and then having seven days off, but he was generally not required to actually work for all of his seven days “on.” Since Tom Miller had some free time, he ran real estate ventures on the side. He owned several rental real estate properties and was also a general contractor, providing various construction services for clients. He performed large amounts of maintenance and repair work on his rental properties. In one property, for example, Tom and his subcontractor built a retaining wall, replaced decks, remodeled a bathroom, installed new gutters, replaced the plumbing, and repaired the furnace. The subcontractor described Tom as a workaholic who performed manual labor for each project on the property, after he was done with his piloting job. Others described his “work ethic as extraordinary” and said they “did not know anyone who worked harder.” Tom created contemporaneous time sheets detailing his time spent on his real estate activities and construction business. The IRS disallowed the Millers’ tax losses from their rental properties for the years at issue (2005 and 2006), which the taxpayers challenged in Tax Court. The Tax Court first analyzed the issue of whether Tom was a real estate professional under the IRC. If he was not a real estate professional, then his losses from rental real estate could only be applied against his other passive income, such as from other rental properties, and those losses could not offset his taxable income from his piloting job and other sources. A real estate professional must generally (i) spend more than 750 hours during the year in real property trades or businesses in which he materially participates, and (ii) those hours must constitute more than half of his time spent performing all personal services that year. Real property trades or businesses include real property construction, condominium development, property brokerage, apartment leasing, and hotel management. The Tax Court held that Tom Miller established that he spent more than 750 hours in each of 2005 and 2006 performing significant construction work both as a contractor and on his rental properties, and that he spent more time on such work than he did on piloting vessels. The court found Tom’s testimony and evidence to be compelling, especially given his contemporaneous time logs for his real estate work and the helpful testimony from various witnesses. However, a real estate professional is not entitled to automatically deduct all of his tax losses from rental real estate activities. While his rental real estate activities are no longer per se passive, such activities are not actually passive only if he materially participates in the activities. There are seven ways that an individual may materially participate in an activity during a taxable year: 1. The individual participates in the activity for more than 500 hours during such year. 2. The individual’s participation constitutes substantially all of the participation in such activeity of all individuals (including those who are not owners of interests in the activity) for such year. 3. The individual participates in the activity for more than 100 hours during such year, and his participation is not less than the participation of any other individual (including those who are not owners of interests in the activity) for such year. 4. The individual significantly participates in the activity, generally by participating for between 100 and 500 hours during the year, and his aggregate participation in all significant participation activeties during such year is over 500 hours. 5. The individual materially participated in the activity for any five of the ten preceding tax years, other than material participation as a result of this test #5. 6. The activity is a personal service activity and the individual materially participated in the activity for any three previous tax years (whether or not consecutive). 7. Based on all the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during such year, and the participation is more than 100 hours. In determining material participation, any hours requirement may include hours spent by both the taxpayer and his wife during the year, even if they are filing separate tax returns. In contrast, in determining whether a person is a real estate professional, he can only count his own time toward the 750 hour threshold. Each of the Millers’ rental properties was treated as a separate activity, because the Millers failed to make a tax election to group them into a single activity, as discussed below. For two of the Millers’ properties, they were able to prove that they participated for over 100 hours per year in the relevant years, and that their participation was not less than the participation of any other individual for those years (test #3). For four other properties, the Millers failed to prove that they participated for over 100 hours in any year, and they could not use material participation test #2 because they could not prove that their participation constituted substantially all of the participation for those properties in the relevant years. Tom Miller’s brother lived next to one of the properties (the Morning Glory property), and the court thought it was possible that he participated in repairs or other work on the property. Analysis A taxpayer may generally group various similar undertakings into a single activity by simply reporting a single activity on his tax return. A person who runs two restaurants, for example, can choose to have one restaurant activity or two restaurant activities for tax purposes. The main advantage of having a single combined activity is that it is easier to achieve material participation, as it is easier to spend more than 500 hours a year on two restaurants combined than on each restaurant. However, there are some benefits in not combining activities, such as a taxpayer who seeks to maintain income-producing activities as passive activities in order to generate passive income. Furthermore, if a taxpayer sells his entire interest in a passive activity, he may recognize any suspended passive activity losses with respect to that activity, but this rule would not apply if the taxpayer is disposing of only part of a combined activity. A taxpayer with three restaurants may choose to group two restaurants in one activity and keep the third restaurant as a separate activity. In contrast to the general flexibility for a taxpayer to group his similar undertakings, a real estate professional is subject to stricter requirements. The IRC specifically provides that a real estate professional must treat each rental real estate activity as a separate activity, unless he affirmatively files an election on his tax return to treat all of his rental real estate activities as a single activity. The Millers failed to make such an election. Had they done so, they probably could have easily proven their material participation in their single combined rental real estate activity, by proving that they spent more than 100 hours on the combined activity (which is more than the participation of any other person) or alternatively by proving that they spent more than 500 hours total on the activity (regardless of the participation by any other person) during the year. The election is governed by Treasury Regulations Search7RH 1.469-9, which provides that the election must be made by filing a statement with the taxpayers’ original income tax return for the relevant tax year. Thus, the Millers should have elected when they filed their original 2005 tax return. The election can only be filed by a real estate professional, who states on the election statement that he is a qualifying taxpayer (i.e., a real estate professsional) for the year and is electing under IRC section 469(c)(7)(A). In Revenue Procedure 2011-34, 2011-24 I.R.B. 875, the IRS established a procedure that allows taxpayers to make late elections retroactively, for any previous tax year. The late procedure is only available if the taxpayer had been filing his tax returns consistently with having made such an election, the taxpayer had timely filed each tax return that would have been affected by the election, and the taxpayer has reasonable cause for failing to file the election timely. If the Millers could show some reasonable cause for not making the election, they might have been able to belatedly elect to group all of their rental properties as a single activity. The election is not advantageous in all circumstances, such as where the real estate professional has unused passive losses from prior years and seeks to generate some passive income. Once filed, the election can be revoked only if the taxpayer demonstrates a material change in his facts and circumstances. The fact that the election became less advantageous (financially), or the fact that the taxpayer ceased to be a real estate professional, does not by itself count as a material change. The election only applies to grouping rental real estate activities together, and thus it cannot group other types of real estate activities. For example, a construction general contractor who spends a small amount of time on rental real estate cannot group the latter activity with his regular job. He would have to prove his material participation in the rental real estate activity by counting only his time spent on that activity. The Tax Court may have given the Millers a break in determining whether Tom Miller is a real estate professional. As mentioned above, a real estate professional must prove that he spent more than 750 hours during the year in all real property trades or businesses in which he materially participates, not just 750 hours in any and all real property trade s or businesses, and those hours must exceed more than half of his total hours of personal service. Thus, for the four rental properties in which the court held that the Millers did not materially participate, Tom Miller’s work with respect to those four properties should not have counted toward his 750 hours total, and in fact should be counted against him in determining whether he spent more than half of his time on real property trades or businesses in which he materially participates. The Tax Court did not itemize the activities on which the 750 hours were spent; the court merely said that Tom Miller spent over 750 hours as “a contractor and on his rental real estate activities.” The court appears to have inappropriately grouped all of the Millers’ rental real estate activities together and presumed their material participation in reaching the 750 hour threshold, but it technically should have disallowed the hours spent on the four non-material-participation properties. Tom Miller admittedly spent less than 100 hours a year on the four properties, but those hours might have been critical for the court in concluding that he spent more than 750 hours and over half his time on real property trades or businesses. The Tax Court tested the Millers’ material participation under only two tests, whether their participation constituted substantially all of the participation in the activity for the year (test #2 above) and whether they participated for more than 100 hours during the year and their participation was not less than the participation of any other person (test #3 above). But the court did not analyze whether the Millers could have materially participated under test #5 above, which provides that the taxpayers are materially participating in an activity if they had materially participated in the activity for any five of the ten preceding taxable years. For example, the Millers owned the Morning Glory rental property for five taxable years (2000 through 2004) prior to the years at issue in the case. If the Millers could prove that they had materially participated in the Morning Glory property activity during those years, then they should be able to use test #5 to prove that they also materially participated in 2005 and 2006 with respect to the Morning Glory property. Even though Tom Miller might not have been a real estate professional during those prior years, he could nevertheless materially participate in an activity, and that material participation should be counted for future years for purposes of test #5. The per se rental real estate rule provides that all rental real estate activities are passive for a non-real-estate-professional regardless of his material participation in those activities, but it does not change the fact that the person did materially participate in those activeties. Conclusion The passive activity loss rules in general, and the real estate professional rules in particular, are a complex area of the tax law and serve many traps for the unwary. The Millers managed the hard task of proving that Tom Miller was a real estate professional, but they nevertheless could not deduct their tax losses from most of their rental properties. As the Miller case has shown, even the most hardworking taxpayer with the best books and records can be stymied by failing to file a simple one-sentence election statement with his tax return.